Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang

1. Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang 10

2. Chapter 10Technical Analysis • Underlying Assumptions • Advantages of Technical Analysis • Challenges to Technical Analysis • Technical Trading Rules and Indicators • Technical Analysis of Foreign Markets • Technical Analysis of Bond Markets

3. Underlying Assumptions of Technical Analysis • The market value of any good or service is determined solely by the interaction of supply and demand • Supply and demand are governed by numerous factors, both rational and irrational • Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time

4. Underlying Assumptions of Technical Analysis • Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself

5. Advantages of Technical Analysis • Technical analysis is not heavily dependent on financial accounting statements. The technician contends that there are several major problems with accounting statements: • Lack information needed by security analysts • GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms • Non-quantifiable factors do not show up in financial statements

6. Advantages of Technical Analysis • Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium • Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust their prices as quickly

7. Challenges to Technical Analysis • For Assumptions of Technical Analysis • Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends • For Technical Trading Rules • The past may not be repeated • Patterns may become self-fulfilling prophecies • A successful rule will gain followers and become less successful • Rules require a great deal of subjective judgement

8. Technical Trading Rules & Indicators • The Rationale • A typical stock price cycle for the market or a stock goes through a peak and trough as well as trends • By analyzing the trend patterns (rising trend, flat trend, declining trend) and the change in trend, a technical analyst would be able to decide what trade is needed

9. Technical Trading Rules & Indicators • Trading Rules • Contrary-Opinion Rules • Follow the Smart Money • Momentum Indicators • Stock Price and Volume Techniques

10. Technical Trading Rules & Indicators

11. Contrary-Opinion Rules • Many analysts rely on rules developed from the premise that the majority of investors are wrong as the market approaches peaks and troughs • Technicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite direction • These positions have various indicators

12. Contrary-Opinion Rules • Mutual fund cash positions • Buy when the mutual fund cash position is high, sell when low • Assumes that mutual fund managers are poor judges of market turning points • Credit balances in brokerage accounts • Buy when credit balances increase, sell when credit balances fall • Investment advisory opinions • Buy when advisory firms become more bearish

13. Contrary-Opinion Rules • OTC versus NYSE volume • If OTC volume increases relative to NYSE volume, sell since speculation increases at peaks • Put-Call Ratio • Buy when option purchasers are bearish (when the put/call ratio increases) • Futures traders bullish on stock index futures • Sell when speculators are bullish

14. Follow the Smart Money

15. Follow the Smart Money • While contrary-opinion rules assume that most investors are not smart, these indicators seek to follow the path of sophisticated, and assumed smart, investors • The Barron’s Confidence Index • Measures the yield spread between high-grade bonds and a large cross section of bonds • Declining (increasing) yield spreads increase (decrease) this index, and are a bullish (bearish) indicator

16. Follow the Smart Money • T-Bill–Eurodollar yield spread • Decreases in this spread indicates greater confidence, and is a bullish indicator • Debit (margin) balances in brokerage accounts • Such balances represent buying on margin, which is assumed to be done by largely sophisticated investors • Increases are a bullish signal

17. Momentum Indicators • Breadth of market • Measures the number of issues increased and the number of issues declined each day • The advance–decline index is typically a cumulative index of net advances or net declines

18. Momentum Indicators • Stocks above their 200-day moving average • The market is considered to be overboughtand subject to a negative correction when more than 80 percent of the stocks are trading above their 200-day moving average

19. Momentum Indicators

20. Stock Price & Volume Techniques • The Dow Theory • The oldest technical trading rule • Stock prices as moving in trends analogous to the movement of water • Three types of price movements over time • Major trends are like tides in the ocean • Intermediate trends resemble waves • Short-run movements are like ripples

21. Stock Price & Volume Techniques

22. Stock Price & Volume Techniques • Importance of Volume • Technicians watch volume changes along with price movements as an indicator of changes in supply and demand • Technician looks for price increase on heavy volume relative to the stock’s normal trading volume as an indication of bullish activity • Conversely, a price decline with heavy volume is considered bearish • Technicians also use a ratio of upside–downside volume as an indicator of short-term momentum for the aggregate stock market

23. Stock Price & Volume Techniques • Support and Resistance Levels • A support level is the price range at which the technician would expect a substantial increase in the demand for a stock • A resistance level is the price range at which the technician would expect an increase in the supply of stock and a price reversal • It is also possible to envision a rising trend of support and resistance levels for a stock

24. Stock Price & Volume Techniques • Moving-Average Lines • Meant to reflect the overall trend for price series • The shorter MA line (the 50-day versus 200-day) reflecting shorter trends • If prices reverse and break through the moving-average line from below accompanied by heavy trading volume, most technicians would consider this a positive change; and vice verse • If the 50-day MA line crosses the 200-day MA line from below on good volume, this would be a bullish indicator

25. Stock Price & Volume Techniques

26. Stock Price & Volume Techniques • Relative Strength • Bar Charting • Candlestick Charts • Multiple Indicator Charts • Point-and-Figure Charts • Overall Feel From A Consensus Of Numerous Technical Indicators

27. Technical Analysis of Foreign Markets • When analyzing non-Canadian markets, many techniques are limited to price and volume data • The reason is that the detailed information available on the Canadian (and U.S.) market is not always available for other countries

28. Technical Analysis of Bond Markets • These technical analysis techniques for stocks can also be applied to the bond market • The theory and rationale for technical analysis of bonds is the same as for stocks, and many of the same trading rules are used • A major difference is that it was generally not possible to consider the volume of trading of bonds because most bonds are traded OTC, where volume was not reported until 2004